Maximize Wealth and Minimize Taxes with the “Buy, Borrow, Die” Strategy
The "Buy, Borrow, Die" strategy is well known for offering a savvy approach for individuals looking to grow their wealth and pass it on to future generations with minimal tax impact. It is known as a strategy for the wealthy, but the basic principles can apply to all individuals with funds to invest. Let us look at how it is applied in practice.
How does it work?
It starts with the “Buy” or investment in assets likely to appreciate over time, such as real estate or stocks, which are not taxed on their gains until they are sold. At this point, good investment decision is crucial to select assets that will increase in value.
When in need of cash, instead of selling these assets and facing a hefty capital gains tax (CGT) bill, individuals can “Borrow” against them, securing loans at favourable interest rates. Raising a loan is not a taxable event, offering liquidity without a tax bill. However, loans must be paid back regularly so this will only work if the individual earns a steady income. The borrowed money can fund lifestyles, further investments, or any financial needs without diminishing the asset's value.
When the individual “Dies”, the assets will be included in the estate at market value and there will be no CGT charged at that point. While estate duty is unavoidable, the market value of the assets will be the new base cost for CGT reducing future capital gains tax liability when the heirs decide to sell the assets. This will result in a saving on CGT.
This strategy, while requiring careful planning and a good understanding of South African tax laws, can be considered to ensure that one's wealth not only grows but does so in a way that is tax-efficient and beneficial for heirs.
What we can know when implementing the “Buy, Borrow, Die” strategy
To ensure the effectiveness of the strategy and compliance consider the following:
Informed asset selection: focus on acquiring assets that are expected to appreciate over time, such as real estate in prime locations or high-growth stocks. The choice of asset is crucial as it underpins the strategy’s success.
Understanding tax implications: have a solid grasp of the tax implications, particularly regarding capital gains tax and estate duty. Knowing how borrowing against assets affects taxes and how the heirs will be taxed upon inheriting the assets is essential. Tax laws and estate duty regulations can change, affecting the viability and benefits of the strategy.
Interest rates and loan terms: when borrowing against assets, assess the interest rates and terms of the loan carefully. The strategy assumes that the cost of borrowing is less than the potential tax savings and asset appreciation, which might not always be the case.
Market conditions: stay informed about market conditions that affect the value of your investments and the interest rates on loans. Economic downturns, for instance, could affect both the asset's value and the cost of borrowing.
Estate planning: incorporate the strategy into a broader estate plan. Consider how assets will be managed and transferred to heirs, including the legal structures used, such as trusts, to optimise tax benefits and ensure a smooth transfer of wealth.
Have a contingency plan: assess the risks, including the possibility of a decrease in asset values or changes in loan conditions. Ensure there's a contingency plan in case the assets decrease in value to a point where they no longer cover the loan balance.
Professional advice: given the complexity of tax laws and financial planning, consulting with financial advisors, tax professionals, and estate planners who understand both the strategy and the local context is crucial. They can provide personalized advice based on your financial situation and goals.
How can this work in South Africa
Let's apply this strategy to a hypothetical South African, Ms. Nkosi:
Step 1 (Buy): Ms. Nkosi invested R10 million in a diversified portfolio. Over 20 years, the value of her investments appreciated to R50 million.
Step 2 (Borrow): Needing R5 million for a new investment, she opts for a loan secured by her assets, thus avoiding the sale and the consequent CGT.
Step 3 (Die): Upon her death, her estate—valued at R50 million—is passed to her children. Estate duty is calculated on this value and this is also the base cost for future CGT calculations should her children decide to sell the assets.
Tax Implications Explained
During Ms. Nkosi’s Life: By borrowing instead of selling, she does not trigger CGT, thereby preserving the full value of her assets. We assume that none of her assets here are exempt from CGT.
Estate duty at death: Her estate is valued at R50 million. After applying the exemption (assuming R3.5 million for this example), the estate faces a duty calculated on R46.5 million, resulting in estate duty costs of R10,125 million as per the calculation below*.
For the Heirs: If they inherit the assets and sell them later for R60 million, they would only face CGT on the R10 million gain above the inherited value. Assuming a 40% inclusion rate and a top marginal tax rate of 45%, the CGT would be around R1.8 million.
*Estate duty is calculated as follows:
The net value for estate duty is R50,000,000 (assuming no deductions for simplicity).
Deduct the exemption of R3.5 million: R50 million - R3.5 million = R46.5 million
Estate duty payable:
20% * R30,000,000 = R6,000,000 (on the first R30 million)
25% * R16,500,000 = 4,125,000 (on the amount over R30 million)
Total estate duty payable = R10,125 million
On the other hand, when an appreciated asset is sold, there is CGT on the profit, which can be as high as 18% for individuals. In this example, the CGT of R40 million can amount to R7.2 million in CGT. Avoiding CGT using the approach described above not only keeps more money in your pocket but also means you can pass on the asset to your heirs without reducing its value through taxes. It's a smart move for anyone looking to manage their wealth and tax liabilities effectively.
